A new trend in derivatives valuation is starting to pull financial reporting in a more volatile direction, as greater consideration for risk in derivatives is starting to dribble into U.S. corporate balance sheets.
In its fourth-quarter earnings announcement, JPMorgan unveiled a $1.5 billion hit to net revenue due to a “funding valuation adjustment” on its derivatives portfolio—that is, an adjustment to reflect the bank’s cost of funding uncollateralized derivatives. JPMorgan said the new approach to valuation “reflects an industry migration” toward incorporating any costs or benefits associated with funding into valuations.
The FVA is an evolving concept spurred by movements in Europe to comply with Basel III, the new international banking regulatory framework that includes a requirement for banks to consider a counter-party’s credit risk in valuing derivatives. At the same time, European banks are complying with a new accounting standard on measuring fair value, intended when it took effect in 2013 to harmonize international accounting standards with U.S. rules.
In applying Basel III and the international standards together, some large European banks started looking more closely at their own and their counter-parties’ risk of default in setting values for derivatives. JPMorgan appears to be the first major bank to adopt that thinking in its U.S. financial statements as well.
Like a red flag on the beach warning that the currents are getting powerful, JPMorgan’s announcement is an alert to others wading in the derivatives market that the tide is shifting and they should beware the tug. “This is new, but it represents a continuation of a movement that’s been happening for years,” says Espen Robak, president of Pluris Valuation Advisors. “It’s a drive toward valuations that are more market-centric.”
Historically, derivative valuation methods have been based on complex models built on long-held assumptions that the markets would always behave rationally, Robak says—“that trading is continuous, that liquidity is never a factor, that counter-party risk never applies,” he says. The financial crisis and years of persistent volatility are (finally) pushing those kinds of valuation assumptions aside. “The movement afoot is going to move all of this quite a bit more into the realm of how we take into account what the market is actually telling us.”
Pinning value to derivatives was tough in the first years after the financial crisis because many derivatives were traded so thinly that getting good numbers on value was difficult. That changed in the United States when the Dodd-Frank Act imposed a clearing system on certain transactions to promote transparency, says Michael Greenberger, law professor at the University of Maryland and a former director for the Commodity Futures Trading Commission. “Dodd-Frank is about moving derivatives onto exchanges so you’re not at the mercy of the ones dealing,” he says. “Once there’s an exchange, there’s an open price, and you can’t ignore it.”
Greenberger suspects that derivative values will continue to fall as other banks follow the lead of those in Europe and now JPMorgan in the United States, which have taken valuation adjustments as a result of more market transparency. “When you’re buying and selling and there’s a readiness to buy and sell, swaps are going to sell at a much lower price,” he says. “So they probably had swaps on the books that they had priced unrealistically high that now the markets are demonstrating should be priced much lower.”
“This is going to be controversial for different people in the marketplace for a while. Operating companies should wait to see what their auditors tell them to do.”
Operating companies that use derivatives to hedge various financial positions (interest rates, foreign exchange rates, commodities or raw materials pricing, and so forth) should rejoice in seeing some downward pressure on pricing, Greenberger says. The existence of a more open market also makes their instruments more liquid should they want to sell, he adds. He believes some are wringing their hands because more transparent trading does introduce some uncertainty to valuation. “They’re used to being told what to do by the banks,” he says.
On the Bandwagon?
Cindy Ma, managing director at international investment bank Houlihan Lokey, says it’s too soon for to start making funding cost adjustments to derivatives positions without some guidance from the auditing profession. The valuation debate is still evolving among those in the trenches, she says, with different views held by the trading community, the accounting profession, and the academic community. Traders are advocating adjustments, academics looking at it from a more theoretical perspective are opposing it, and the auditing profession is still trying to sort out the best approach, she says.
CREDIT VALUATION ADJUSTMENTS
Below is an excerpt from EY’s survey on derivative valuation on companies recording credit valuation adjustments.
Accounting standards, both IFRS and U.S. GAAP, make it clear that credit risk should be reflected in the fair value of derivatives. However, of the survey participants only 2 companies record a CVA on derivative portfolios for counter-parties with positive current exposure in 2012, and 2 companies will record a CVA in 2013.
Credit risk on derivative portfolios is one of the most complex risks to measure. There is significant uncertainty around Exposure at Default (EAD) as well as on the probability of default (PD) and the loss given default (LGD). In understanding why most of the participants did not record a CVA in their 2012 accounts, many responded that based on initial (often qualitative) assessments the impact is deemed insignificant, or that it is considered unpractical to determine credit risk.
Contrary to financial organizations that often have separate credit risk departments, such headcount is often not available or feasible at the non-financial companies included in this survey. Whereas CVA is often calculated by financial organizations using the formula: EAD * PD * LGD, the determination of all three elements is often seen as too complex for non-financial organizations.
In analyzing the reason for a why a CVA was not recorded we determined that that those entities that performed a quantitative assessment concluded the impact of CVA on the financial statements to be immaterial. In some cases only qualitative assessments were performed, but by entities that have either collateralized derivatives in place; that only deal with counter-parties with high credit ratings; or that have short dated derivatives, thus concluding that CVA will be immaterial if calculated. Some respondents indicated that they did not perform a quantitative assessment due to a lack of appropriate valuation models. Even if the potential impact could be immaterial for the financial statements, all organizations are required to perform at least a quantitative assessment of this potential impact.
It appears none of the Big 4 firms have commented publicly in the United States to weigh in on the debate.
“This is going to be controversial for different people in the marketplace for a while,” Ma says. “Corporates and end users should wait to see what their auditors recommend. If one holds several positions for hedging purposes and must comply with accounting standards, it would be premature to change those positions and alter current methodology without guidance from the auditors.”
Still, Ma is concerned about the reporting arbitrage and the inconsistency in financial statements that could develop while preparers operate in uncertainty and await guidance to settle the debate. “Somehow there has to be some consistency in what the right practice will be,” she says. “Otherwise, it will be difficult to analyze financial statements.”
She worries that preparers could begin making decisions about whether to take risk-based funding valuation adjustments based on whether the adjustment would help or harm their own financial positions. Ma also raises concern about the expertise necessary to tweak valuations, and whether smaller organizations will be able to handle it should they be required or directed to do so.
The “FVA movement” represents yet another example of how judgment is demanded in financial reporting and is difficult to apply, says Jerry Arcy, managing director for financial advisory and investment banking firm Duff & Phelps. “You could get reasonably sophisticated people in a room on a portfolio of interest rate derivatives or credit spread derivatives, and their views on how audit sales will play out could be reasonably different,” he says. “What you have here is an evolving focus on a lot more subtle differences between counter-party risk and the techniques used to measure it. That’s not to say it wasn’t done before, but it wasn’t done with the same clarity or consistency. That’s what is evolving.”
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